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Empirical Evidences Based on Time Series

Data from Pakistan

SHAHID ALI and NAVED AHMAD*

1. INTRODUCTION

Fiscal policy refers to governments efforts to influence the direction of the

economy through changes in taxes or expenditures. Optimal fiscal policy in Pakistan and

in other developing countries plays a pivotal role in growth process and, hence, serves as

a vital instrument for economic growth. The efficacy of fiscal policy in improving

economic conditions in the long run is, however, a controversial issue and needs further

investigation.

In conventional model, a federal tax cut without a corresponding reduction in

federal expenditures will encourage consumption expenditures and interest earning s

due to increase in personal disposable income. Contrarily, according to Ricardian

Equivalence Theorem (RET), the same change in fiscal policy will not result in any

of the above mentioned macroeconomic impacts. In other words, a reduction in

deficit-financed federal tax cut will not affect macroeconomic outcomes [Saxton

(1999)].

The empirical literature on the effects of fiscal policy on Pakistans economic

growth is still at its infancy, we surmise. Shabbir and Mahmood (1992), Iqbal (1995,

1994, 1998), Khilji and Mahmood (1997) have concluded that fiscal deficit is one of the

significant variables that affects economic growth in Pakistan. Haq (2003), on the other

hand, has argued that fiscal deficits do not have any effect on key macroeconomic

indicators such as investment, inflation and GDP growth. The impact of fiscal policy on

economic growth can also be demonstrated and explored through transmission

mechanism; it affects economic growth via demand and supply sides. According to

Khalid, et al. (2008) fiscal policy is considered to have dynamic transmission

mechanism, as it carries longer policy lags for different macroeconomic variables and

hence, it has different impacts on key macroeconomic variables.

Pakhtunkhwa. Naved Ahmad <navedahmad@hotmail.com> is Associate Professor and Chairman, Department

of Economics and Finance, Institute of Business Administration (IBA), Karachi.

Authors Note: We are thankful to Syed Akbar Zaidi, Haroon Jamal and Khalid Mahmood for their

helpful comments and suggestions. We are, however, responsible for the views expressed in this paper and any

remaining errors.

498 Ali and Ahmad

Recognising the importance of sound fiscal policy, the present study explores the

link between fiscal policy and economic growth for Pakistans economy for the period

19722008. The study also examines the effectiveness of fiscal policy in different

political regimes. Using dynamic model and various econometric techniques, this study

tests the significance of various empirical models. The study also imparts some policy

recommendations for the development of sound fiscal policy in Pakistan. This study is

the first empirical analysis on the effectiveness of fiscal policy and its impact on

economic growth in Pakistan.

The rest of this study is organised as follow: Section 2 presents the summary of

review of literature on the effects of fiscal policy on economic growth in different parts

of the world. Section 3 presents the model specification and methodology. Section 4

represents the empirical findings and the last section provides concluding remarks and

policy implications.

2. LITERATURE REVIEW

The macroeconomic relationship between fiscal policy and economic growth has

long fascinated economists. Unfortunately, analyses of that relationship have

frustrated empiricists for almost as long. One root of that frustration is the array of

possible policy indicators [Fu, et al. (2003)].

A large number of studies have been carried out to examine the impact of fiscal

policy variables on economic growth, investment, consumption, inflation, exchange rate,

external deficit and other macroeconomic activities [Landau (1986); Hoppner (2003);

Perotti (2005), Amanja and Morrissey (2005); Falk, et al. (2006); Rezk (2006); Castro, et

al. (2006); Fatas and Mihov (1998); Sinha (1998); William and Orszag (2003); Claus, et al.

(2006) and Kukk (2006)]. Government spending, tax revenues and budget deficits as fiscal

policy variables have been used by these authors and found different responses of

macroeconomic activities to fiscal innovations. According to Hoppner (2003), Claus, et al.

(2006), Esau (2006), Heppke-Falk, et al. (2006) and Castro, et al. (2006), shocks to

government spending positively affect GDP growth rate, whereas shocks to taxes inversely

affect GDP growth rate. Furthermore, GDP growth rate responds negatively to budget

deficit in the long run [Balassa (1988); Iqbal and Zahid (1998); Jafri, et al. (2006)]. Many

researchers [Barro and Sala-i-Martin (1995); Sala-i-Martin (1997); Mendoza, et al. (1997);

Tanzi and Zee (1997); Kneller and Gemmell (1999); Odedokun (2001); and Bose, et al.

(2003); Amanja and Morrissey (2005); Romero de Avila and Strauch (2007)] have used

fiscal policy variables in the growth equations and have found their significant contribution.

The rising budget deficit has been considered as one of the main constraints to economic

growth [Iqbal and Zahid (1998); Fischer (1993); Easterly and Rebelo (1992); Levine and

Zervos (1993); Barro (1991); Mwebaze (2002) and Balassa (1988)]. From the relevant

literature it is clear that fiscal policy affects economic growth. However, the sign and

magnitude of the effects of different tools of fiscal policy are ambiguous.

Only few studies have examined the effects of fiscal policy on specific

macroeconomic variables in Pakistan [Ahmad and Qayyum (2008); Haque and Montiel

(1991); Khalid, et al. (2008)]. Few studies have included budget deficit in growth

equations and have found that budget deficit is one the significant variables affecting

Effects of Fiscal Policy on Economic Growth 499

economic growth [Shabbir and Mahmood (1992); Iqbal (1994, 1995, 1998); Khilji and

Mahmood (1997)]. As far as theoretical work regarding the relationship between fiscal

policy and economic growth is concerned, the most notable work has been done by

Trevala (2005) and Blinder and Solow (1972). Tervala (2005) argued that fiscal growth

raises the output of non traded goods and crowds out private consumption of non traded

goods. However, Blinder and Solow (1972) argued that in the simplified ISLM

framework the long run sign of the pure fiscal multiplier is undermined a priori, fiscal

policy only acts perversely in unstable system.

In order to examine the effects of fiscal policy on economic growth, we estimate

the following equation.

Yt = o + 1 FPt + 2 Xt + 3 (FP*DUM)t + (1)

Where Y = Growth rate of GDP per capita, vector X represents the set of control variables

i.e., private investment (PINV), inflation (INF), current account deficit (CAD) and FP

represents Fiscal Policy variables. In the above equation changes in FP variables has a

dynamic impact on Y. Further, to capture the effects of fiscal policy in democratic and

military regimes, we include the interaction term of fiscal policy with political dummy.

We use overall fiscal deficit as a proxy of fiscal policy.

The data for this study consist of annual observations for the period 19722008.

The most important data source is Economic Survey of Pakistan (Government of

Pakistan). A multivariate framework is employed in this study.12

3.2. Methodology

This study concentrates on the ADF and PP and NgPerron unit root tests. To test

the long run relationship, this study uses the robust econometric technique,

Autoregressive Distributed Lag model (ARDL), popularised by Pesaran and Shin (1998),

and Pesaran, et al. (2001).

The error correction version of ARDL model is given below for the above given

Equation (1).

p p p

Yt 1 Yt i 2 FPt i 3 X t i 1Yt 1 2 FPt 1 3 X t 1 (2)

i 1 i 0 i 0

Where Y represents real GDP growth rate, FP represent fiscal policy variables such as

fiscal deficit as a percent of GDP (FD), current expenditures as a percent of total

expenditures (CE) and development expenditures as a percent of total expenditures (DE).

X represents control variables. 0 is drift component and is white noise.

In order to find out the short run coefficients, we use the following equation:

p p p

Yt 1 Yt i 2 FPt i 3 X t i ECtI (3)

i 1 i 0 i 0

1

See Appendix 1 for the definitions of variables.

500 Ali and Ahmad

is the error correction term in the model indicates the pace of adjustment reverse

to long run equilibrium following a short run shock.

Private investment is measured by the sum of business fixed investment,

residential investment and inventory investment. Moreover, current account balance is

measured by the sum of net exports of goods and services, net income from abroad (Net

Factor Payment) and net unilateral transfers.

Samudram and Vaithilingam (2009) in case of Malaysia and Mohammadi, et al.

(2008) in case of Turkey used Autoregressive Distributed Lag model (ARDL) to examine

the impact of public expenditure on economic growth.

To cope up with the endogeneity of explanatory variables, and to avoid

inconsistent results, this study uses two-stage least Square (2SLS) instrumental variable

techniques.

ADF test, PP test and NgPerron unit root test were applied in order to test the unit

root hypothesis to all variables. A summary of these test results is reported in Table 1.

Table 1

Unit Root results

ADF (Drift and Trend) P- P (Drift and Trend)

Variables Level 1st Diff Level 1st Diff

Notes: *(**) Shows significance at 1 percent (5 percent) level.

Results show that each of the variables is integrated of different order. The

results of the unit root tests enable us to apply any cointegration technique. The

results of ADF and PP unit root tests show that all variables are integrated of order

one except PINV and CAD. The results of Ng-Perron unit toot test show that all

variables are integrated of order one except CAD. The results of Ng-Perron unit root

test are given in Table 2.

Effects of Fiscal Policy on Economic Growth 501

Table 2

Ng-Perron Unit Root Results

Ng-Perron Test Statistics

At Level

MZa MZt MSB MPT

Y 0.62 0.23 0.37 37.15

FD 36.0 134.29 0.01 0.01

PINV 9.69 2.12 0.21 9.71

PCON 1.79 0.49 0.27 24.08

INF 1.86 0.84 0.45 40.55

CAD 17.96** 2.99 0.16 5.07

At 1st Difference

MZa MZt MSB MPT

Y 17.61* 2.96 0.16 5.19

FD 3.76* 39.11 10.37 3.10

PINV 12.13*** 2.46 0.20 7.51

PCON 15.03*** 2.719 0.18 6.18

INF 55.82* 4.80 0.08 3.77

CAD 13.39** 2.58 0.19 6.80

Notes: *(**) Shows significance at 1 percent (5 percent) level.

growth equations and select three of them for comparison. These equations have been

estimated via ARDL co-integration technique.

After finding integrating order of all variable, the ARDL co-integration system is

implemented for Pakistan utilising annual data over the period 19722008. In the first

stage, the order of lag length is usually obtained from unrestricted vector autoregressive

(VAR) via Schwartz Bayesian Criteria (SBC) and Akaike Information Criteria (AIC).

The order of lag length is 2 which is selected through the minimum value of SBC as

shown in Table 3.

Table 3

Lags Defined through VAR-SBC for Overall Model

Lag Selected through VAR-SBC

Lag Growth Equation

0 104.69

1 91.73

2 90.33*

3 90.55

Notes: *Indicates minimum Schwarz SBC at the corresponding lag.

502 Ali and Ahmad

Therefore, lag order 2 is selected on lowest value of SBC in Table 3 for the growth

equation. In the next step, we determine individual lag order for the estimation of ARDL,

which is (2, 2, 2, 2, and 0). Finally, the F-test Statistics is estimated on the basis of Wald-

test. The results are given in the following Table 4.

Table 4

Lag Length Selection and Bound Testing for Cointegration

Modal 1 (Growth Equation)

Order of the lags AIC HQ SBC F-test Statistics

K=1 116.65 118.57 117.28 2.31

K=2 113.98* 117.55* 115.17* 5.75**

Short run Diagnostic Tests

Serial Correlation LM tests = 1.65 (0.32)

ARCH Tests: 1.54 (0.24)

White Hetroscedasticity Test: 0.76 (0.34)

Ramsey RESET = 1.02 (0.87)

Jarque-Bera Tests= 897.45 (0.00)

*(**) Significant at 10 percent (5 percent) level of significant according to Pesaran, et al. (2001) and Narayan (2005).

statistically significant for growth equation and higher than upper bound critical value at

5 percent level of significance implying that there is a co-integration among the variables

in the models. The stability of long run relationship among the variables in the model is

also clear from the cumulative sum (CUSUM) stability test.23 Having found a long run

relationship, we apply the ARDL method to estimate the long run and short run

coefficients.34 Long run results are shown in Table 5.

Table 5

Estimated Long Run Coefficients Using the ARDL45

Dependent Variable ARDL Technique

Real GDP Growth Rate (Y) Order (2, 2, 2, 2, 0)

Regressors Coefficients Coefficients

FD 1.64* 1.04*

PINV 0.26 * 0.19*

INF 0.05** 0.06***

CAD 0.83* 0.91*

FD2 0.04*

FD *DUM 0.51***

R2 = 0.99 R2 = 0.99

Adjusted R2 = 0.99 Adjusted R2 = 0.99

F-statistics = 1298.2 F-statistics = 1576.2

Dh Stat = 2.14 Dh Stat = 1.81

Note: *, ** and*** represent Significant at 1 percent, 5 percent and 10 percent level of significance.

2

The results of CUSUM are given in Appendix 3.

3

For details see Pesran, et al. (2001).

4

ARDL order is (2, 2, 2, 2, 0) selected based on SBC.

Effects of Fiscal Policy on Economic Growth 503

GDP (PINV ), inflation rate (INF), current account deficit as a percent of GDP (CAD) as

explanatory variables in growth equation. An interaction term of fiscal deficit with

dummy of democracy is also included in the growth equation.

ARDL technique provides best results in the presence of endogeneity. 56The

explanatory variables and their lags are used as instruments. It is clear from Table

5 that all variables have expected signs and parameters are significant. The long

run results suggest that all variables are important factors affecting economic

growth. The coefficient of fiscal deficit is negative and significant at 1 percent

level of significance indicating that expansionary fiscal contraction occurs in

Pakistan. In the long run rising fiscal deficit reduces national savings and slows

down economic growth. These results support the findings of other studies, which

evidenced that fiscal deficit negatively affects economic growth [Balassa (1988);

Barro (1991); Easterly and Rebelo (1992); Levine and Zervos (1993); Fischer

(1993); Barro and Sala-i-Martin (1995); Mendoza, et al. (1997); Tanzi and Zee

(1997); Kneller and Gemmell (1999); Odedokun (2001); Mwebaze (2002); Bose, et

al. (2003); Ali (2005); Amanja and Morrissey (2005); Jafari, et al. (2006); Kukk

(2006); Romero de Avila and Strauch (2007)]. The results of this study also

support the findings of the studies in Pakistan [Shabbir and Mahmood (1992); Iqbal

(1994, 1995); Khilji and Mahmood (1997); Iqbal and Zahid (1998)]. The main

reason of expansionary fiscal contraction in Pakistan is that government activities

are mostly politically motivated and unproductive and therefore restrains growth.

Moreover, the huge fiscal deficit is due to non development expenditures. Only

interest payment of public debt and defence expenditures exceed the development

expenditures. Due to these reasons fiscal deficit negatively affects economic

growth in the long run. The coefficient of Private investment is significant and its

positive sign indicates that high level of investment increases the productivity and ,

hence, accelerates economic growth. The results show that inflation negatively

affects economic growth. This is due to the fact that inflation decreases domestic

demand and increases the cost of production. These factors decelerate economic

growth. Another important inference drawn from the above result is that the sign of

interaction term is negative and significant indicating that fiscal deficit is

negatively affecting economic growth in military regime. The sign of current

account balance is negative and significant at 1 percent level of significance; it

indicates that an increase in current account deficit decreases the foreign exchange

reserves with host country and hence, reduces economic growth. The coefficient of

fiscal deficit is positive when the square term of fiscal deficit is introduced in the

model. The square term with negative coefficient is the indication of fiscal deficit

Laffer curve in case of Pakistan. It means that fiscal deficit is not a problem up to

some threshold level.

5

To check the robustness of the model, we provide the results of 2SLS in Appendix 2. From the results

of both techniques (ARDL and 2SLS) it is clear that the parameters of the model are not sensitive to change in

econometric technique and hence, it shows the robustness of the model.

504 Ali and Ahmad

Table 6

Estimated Short Run Coefficients Using the ECM

Dependent Variable ARDL Technique

Change in Real GDP Growth Rate (Y) Order (2, 2, 2, 2, 0)

Regressors Coefficients

FD 0.28**

PINV 0.17***

INF 0.08*

CAD 0.98

FD*DUM 0.56

ECt1 0.43*

R2 = 0.81

R2 adjusted = 0.79

Note: *, ** and*** represent Significant at 1 percent, 5 percent and 10 percent level of significance.

The estimated lagged error correction term EC (1) is negative and highly

significant. The negative and significant error correction term also indicates that there is a

long run relationship among the variables Y, FD, PINV, INF and CAD. The feedback

coefficient is 0.43. It suggests that about 43 percent disequilibrium is corrected in the

current year. The result also suggests that in the short run fiscal deficit has significant

impact on economic growth. In the short run, increase in fiscal deficit leads to a decrease

in the real gross domestic product. However, in the short run changes in CAD and

FD*DUM have insignificant impact on economic growth.

Even though we have given the model specification, yet for the purpose of

estimation, we conduct sensitivity analysis and use only robust variables, which are

not sensitive to different econometric techniques. For this purpose, we run a lot of

regressions and choose the most robust variables for our analysis. The robustness of

the variables is also apparent from the short run diagnostic test. From the results of

the short run diagnostic tests it is clear that there is no serial correlation and

hetroscedasticity in the model. To detect the problem of autocorrelation and

hetroscedasticty, we use serial correlation Lagrangian Multiplier (LM) and

autoregressive conditional heteroskedasticity tests respectively. In order to test the

normality of error term, we use Jarque-Bera test. From the calculated value of

Ramsey RESET test it is clear that the functional forms of the models are cor rectly

specified. Moreover, the data is normally distributed. In order to analyse the stability

of long run and short run coefficients, the CUSUM and CUSUMsq stability test are

applied. The results of CUSUM and CUSUMsquare show that all variables are

cointegrated. Moreover, the results show that neither the CUSUM nor the CUSUMsq

test statistics exceed the critical values, which ensure that all models are stable and

correctly specified. Furthermore, the robustness of the variables is also apparent

from the constancy of parameters by using both ARDL and 2SLS econometric

techniques. The models are not sensitive to changes in econometric techniques.

Effects of Fiscal Policy on Economic Growth 505

In this study we examine the dynamic effects of fiscal policy on macroeconomic

activities over the period 19722008. ADF test, PP test and Ng Perron unit root test are

applied to test the unit root hypothesis to all variables. The results of ADF and PP unit

root tests show that all variables are integrated of order one except CAD and PINV. The

results of Ng-Perron unit root test show that all variables are integrated of order one

except CAD. The results of the unit root tests enable us to apply ARDL co integration

techniques.

Using modern econometric approaches, the results show that there is a long run

relationship between overall fiscal deficit and economic growth. It is clear from growth

equation that all variables are important factors affecting economic growth. The negative

and significant coefficient of fiscal deficit indicates that expansionary fiscal contraction

occurs in Pakistan. The main reason of expansionary fiscal contraction in Pakistan is that

government activities are mostly politically motivated and unproductive and therefore

restrains growth. The huge fiscal deficit is due to non development expenditures.

Using the non linear equation, we find that fiscal deficit positively affects

economic growth up to some threshold level. Beyond that threshold level, fiscal deficit

negatively affects economic growth and has some serious macroeconomic consequences.

For short run dynamics. Error Correction Mechanism (ECM) has been used. The

results of ECM suggest that in the short run overall fiscal deficit exert significant impact

on economic growth. This reveals the fact that in the short run rising fiscal deficit creates

excess demand, which encourages firms to use more of their existing capacity and people

to spend more, and hence economic situation in the short run improves, but in the long

run rising fiscal deficit has some serious implication for economic growth. The feed back

coefficient is negative and significant suggesting that about 0.43 percent disequilibrium

in the previous period is corrected in current year.

The study recommends that the government should keep its budget deficit in the

narrow band of 3 to 4 percent of GDP. Beyond this limit the unsustainable budget deficit

could have undesirable macroeconomic costs and the governments macroeconomic

objectives such as low inflation and high economic growth might be in jeopardy. If the

government is able to reduce its budget deficit, eventually she would get rid of the

vicious circle of debt overhanging problem, because the debt-GDP ratio would increase

only if the fiscal deficit as a percentage of GDP exceeds the real GDP growth rate.

However, the reduction in fiscal deficit must be due to reduction in the public

expenditure rather than an increase in resource mobilisation. The government should

curtail non productive expenditures; high attention should also be given to the Public

Sector Development Plan (PSDP), as it has a long term impact on economic growth.

506 Ali and Ahmad

Appendices

APPENDIX 1

DEFINITION OF THE VARIABLES

The definitions of all variables (explanatory variables and instrumental variables)

used in this study are given below.

Overall Budget Deficit/Surplus = (Current Account Expenditures + Development

Expenditures) (Repayment of Foreign Debt) (Net Revenue Receipts) (the

contribution by autonomous bodies) (The amount earned by disinvestment of shares).

Economic Growth = Growth rate in Real Gross Domestic Product (GDP)

Gross Private Domestic Investment = (Business Fixed Investment + Residential

Investment) + (Inventory Investment)

Current Account Balance = Net Exports of Goods and Services + Net Income

from abroad (NFP) + Net Unilateral Transfers

Inflation = Consumer Price Index (Inflation rate)

Public Debt = Total public debt as a percent of GDP.

Exchange Rate = Real exchange rate

Interest Rate = 6 months T- bill rate for short run and 9 months T-bill rate for

long run.

Money Supply = M1 + Saving Deposits including MMDAs (Money Market

Deposit Accounts) + Small Denomination time Deposits + MMMFs (Money Market

Mutual Funds).

APPENDIX 2

EMPIRICAL RESULTS USING 2SLS

Table 1

Estimated Coefficients Using 2SLS Techniques

Dependent Variable 2SLS

Real GDP Growth Rate (Y) Technique67

Regressors Coefficients

FD 1.11**

PINV 0.21*

INF 0.03***

CAD 0.69***

FD2

FD *DUM 0.12**

R2 = 0.97

Adjusted R2 = 0.96

F-statistics = 1532.06

Dh Stat = 1.86

Note: *, ** and*** represent Significant at 1 percent, 5 percent and 10 percent level of significance.

6

INT, M2, ER, PD and all of the variables in the growth equation that are believed to be uncorrelated

with the disturbances are used as instrumental variables.

Effects of Fiscal Policy on Economic Growth 507

APPENDIX 3

RESULTS OF CUSUM AND CUSUM SQ78

20

15

10

-5

-10

-15

-20

1980 1985 1990 1995 2000 2005

CUSUM 5% Significance

1.6

1.2

0.8

0.4

0.0

-0.4

1975 1980 1985 1990 1995 2000 2005

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